When a supplier is selected, the next step is to decide on the type of contract to be signed.
There are different types of contracts. Some examples are as follows: • Fixed-price contract: This is a contract where payment is fixed and
agreed on between the parties. In this type of contract, the risk of cost overrun is on the side of the vendor (the supplier).
151
Interface with Suppliers and Subcontractors
• Cost plus fixed-fee contract: This is a contract where the buyer prom- ises to cover all the costs plus a predetermined fee that was agreed on at the time of contract signing.
• Cost plus incentive fee contract: This is a contract where a larger fee is awarded if the vendor/supplier meets or exceeds performance targets, including cost savings.
• Cost plus award fee contract: This is a contract where the buyer pays a fee based on the vendor/supplier’s work performance.
• Cost plus percentage of cost: This is a contract where the buyer pays a fee that rises as the vendor/supplier’s costs rise.
The selection of the right form of a contract is based on the degree of uncer- tainty in the definition of the product or service, the degree of uncertainty in assessing the cost, and of course, market forces, such as supply and demand in the existing product or service, and the relative merits of the contract viewed by each of the sides (the supplier and the purchaser).
After signing the contract at the end of the selection process, the focus shifts to the management of the ongoing relationship with the supplier or contract management. Pence and Saacke (1988) define three categories of relationships between buyers and suppliers, focusing on quality issues: 1. Testing: The buyer uses product testing to prevent defects. This is
usually done in situations of one-time procurement, when the buyer does not know how good the supplier’s processes and products are, and relies on acceptance testing of the goods.
2. Prevention: The buyer uses his or her expertise to teach the supplier how to achieve the required product and process quality, with the aim of building a foundation for a long-term relationship; the buyer helps the supplier develop defect-free manufacturing processes in an effort to build cooperation with the supplier.
3. Partnership: A long-term relationship between the buyer and the sup- plier is built, based on teamwork between the two parties in the design, manufacture, and supply of the goods and services as required. For example, Toyota helps suppliers set up factories close to its
plants. The purpose of this is to reduce inventory and transportation costs and improve the delivery process. As a result of physical proxim- ity between supplier plants and Toyota assembly plants, shipping costs are reduced and the relationship between Toyota and the supplier is carefully maintained. When this type of close partnership is achieved, the buyer and supplier can align their information systems to improve the flow of information and, consequently, improve the decision mak- ing. Such capabilities enable the supplier to send parts directly to the assembly line, to the point where they are needed (Ihara, 2007).
The level of cooperation between the buyer and supplier can take differ- ent forms. The traditional approach is based on a bidding process where the winning bidder receives a one-time contract that defines the required goods, quantities, due date, cost, and terms of payment. In case of nonstandard items, a technical specification is added. This approach usually requires test- ing. This means that products are shipped to a reception area (sometimes a special warehouse), where they are tested and stored until they are needed for the production process. The added cost of handling components or mate- rials, holding them, testing them, and shipping them is quite significant.
A different approach is to sign a long-term (e.g., annual) contract with a supplier, based on a cost per unit, the estimated total requirements and the promised delivery time. The customer’s (buyer’s) planning and control sys- tem periodically issues supply orders directly to the supplier’s planning and control system. When this form of cooperation is used, there is no need to negotiate the price and terms of each order during the agreement period, and the two sides build long-term relationships. When both parties are using information systems, such as a material requirements planning (MRP) sys- tem or an enterprise resource planning (ERP) system, it is possible to link the systems and transfer requirements for periodic shipments electronically.
A third approach is based on the idea of “just in time” (JIT). In this case, the supplier sends frequent shipments (sometimes several times a day) directly to the assembly line or production line. This is possible when there is an established supplier, and a long-term system based on a relationship of trust. In such cases, the supplier is a true partner in the production process, and therefore, executes quality assurance testing before making the shipments. This form of partnership can develop in situations where the buying organi- zation transfers a whole process or a whole function to one of its suppliers, which is known as outsourcing (Chapter 6).